Stealth Taxes Consume Stock Gains and Retirement Plans, Part 2

By: Daniel Amerman | Wed, Oct 30, 2013
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What if bottom line investment results for a nation as a whole were very different than the great majority of investors understood? What if most long term investment plans were based on what could be quite easily shown to be "bad information"?

These questions may seem a little difficult to accept, because clearly, with the continuous stream of news, commentary and analysis about investment markets that are available 24/7 in newspapers, magazines, blogs and cable business news - such a discrepancy couldn't exist.

Or could it?

In this researched-based tutorial, we're going to take the conventional wisdom about stock market performance and apply two very simple - and irrefutable - truth tests to what real historical results have been. These "truth" tests consist of adjusting for inflation, and adjusting for taxes.

The premise behind these two simple truth tests is that what matters when it comes to investment performance over the long term is what your investments will buy for you after you've paid your taxes. Which means that adjusting for inflation and taxes is not optional - but mandatory.

S&P 500 Index: Real After-Inflation and After-Tax Profits

As is illustrated in the graph above, once we take these two simple steps, and apply them to 15 years of real-world performance of the Standard & Poor's 500 Stock Index on a total return basis, we will find that for stock investors across the United States - there has been a 93% failure to perform. In other words, if we take common market assumptions from the late 1990s and we compare actual performance, 93% of expected investment results for the nation as a whole disappear like vapor.

Which then leads to the next logical question. If some investors clearly understand the issues, whereas most investors do not - does that open up opportunities for this minority of investors?

Adjusting Price Returns For Inflation And Taxes

This analysis is Part Two of the Stealth Stock Taxes Consume Market Gains & Retirement Plans series. It can be read on its own, or it can just as easily be read as the beginning of the series as it can the end of the series.

What we will do is fully integrate two essential factors - inflation and taxes - which MUST be taken into account if we are to get to the true investment bottom line of the purchasing power of our investments after the payment of taxes.

In Part One of this series, we took a look at price returns only on the S&P 500 from the end of 1997 through the end of 2012, and based on an assumed starting portfolio of $100,000, developed the graph and chart below.

S&P 500 Index: Real After-Inflation and After-Tax Profits

S&P 500 Real Earnings & Tax Calculations

As shown, what appeared to be an almost 50% increase in the value of stock portfolios for investors across the country, turned out to be a mere 2.7% increase once we adjust for the change in purchasing power of the US dollar.

When we add the consideration of taxes - which are assessed on nominal pre-inflation earnings, not inflation-adjusted changes in purchasing power - then it is a relatively simple matter to show that the average investor in a combined 30% federal and state tax bracket, who had purchased a stock portfolio at the end of 1997 and sold at the end of 2012, would indeed, despite the surface appearance of a 50% profit, have instead lost 7% of their starting net worth - with no real profits whatsoever - once we adjust for inflation and taxes.

The appearance of a 50% profit is based on the newspaper headline approach to looking at market returns, which is the way most people look at the markets. They expect most of their money to come from changes in price levels, which are not generally adjusted for inflation.

Simply adjust for inflation and paying taxes, however, and all profits are taken, as well as a sizeable chunk of starting net worth. This is true whether taxes are paid on an ongoing basis, or as long-term capital gains, or as ordinary income when drawing down a tax-deferred retirement account.

Adjusting Total Returns For Inflation

Now while looking at price movements is a good first step, and reflects the price focus of many investors, when we move to a professional perspective we can't just stop there.

That is, the true source of most returns for stock investors over the long term has historically not been price movements, but the receipt of dividends, the reinvestment of those dividends, the reinvestment of the dividends from the reinvestments, and so forth. This is the real core of the financial mathematics behind most long term investment models, and it generates a compounding of wealth over time which is both far more profitable and substantially more stable than price movements only.

In my recent article, Growing Wealth With Stocks: Theory Versus Our New Reality, we took a look at the S&P 500 on a total return basis - including price changes, dividends and dividend reinvestments - over a 15.5 year period (which is slightly different from this article). We started with an assumed initial investment of $100,000 at the end of 1997, and looked at how much it would be worth by July of 2013.

Growing Welath: Expected vs Actual

Growing Welath: Expected vs Actual


As demonstrated in that article, in pre-tax terms and for the nation as a whole, when we look at total return on the S&P 500 for that period between the end of 1997 and the middle of 2013, there has been about a 65% failure to perform on an inflation-adjusted basis. And as further explored in detail, if we take a common assumption of an 8% compounding rate from the late 1990s, and we examine results for the next 15 years, we find that even after fully adjusting for assumed dividends and dividend compounding - the stock market in the real world produced only about one third of the compounded wealth that most investors expected it to.

So to understand why so many pension funds have been in such trouble, and why so many investors are deferring retirement, the explanation can be found in the fact that two thirds of the assumed wealth that was built into so many financial planning models has simply failed to materialize. And this has been a particular problem for tens of millions of Boomer investors who were counting on that wealth growing in their accounts in these critical 15 years near the peak or end of their working careers, when most of their investment gains were supposed to occur.

Total Returns & Real Tax Rates

Now let's use the same methodology we did with our price-only analysis, and apply it towards understanding the dramatic impact of inflation taxes on total return.

S&P 500 Index: Real After-Inflation and After-Tax Profits

S&P 500 Real Earnings & Tax Calculations

The second half of the article is linked below. Subjects include:

Continue Reading The Article



Daniel Amerman

Author: Daniel Amerman

Daniel R. Amerman, CFA

Dan Amerman

Daniel R. Amerman is a financial futurist, author, speaker, and consultant with over 20 years of financial industry experience. He is a Chartered Financial Analyst (CFA), and holds MBA and BSBA degrees in Finance from the University of Missouri. He has spent seven years developing a large, unique and intertwined body of work, that is devoted to using the foundation principles of economics and finance to try to understand the retirement of the Baby Boom from the perspective of the people who will be paying for it.

Since 1990, Mr. Amerman has provided specialized quantitative consulting services to financial institutions, with a particular emphasis on structured finance. Previously, Mr. Amerman was vice president of an institutional investment bank, with responsibilities including research, synthetic securities, and capital market originations.

Two of Mr. Amerman's previous books on finance were published by major business publishers. "COLLATERALIZED MORTGAGE OBLIGATIONS, Unlock The Secrets Of Mortgage Derivatives", was published by McGraw-Hill in 1995. Mr. Amerman is also the author of "MORTGAGE SECURITIES: The High-Yield Alternative To CDs, The Low-Risk Alternative To Stocks", which was published by Probus Publishing (now a McGraw-Hill subsidiary) in 1993. Advertised by the publisher as a professional "bestseller" for four quarters, an Asian edition was sold as well.

Mr. Amerman has spoken at numerous professional seminars and conferences nationwide, for a variety of sponsors including New York University, the Institute for International Research, and many others. After the publication of his prior books, he acted as keynote speaker at a number of banking related conferences over the next several years.

This article contains the ideas and opinions of the author. It is a conceptual exploration of general economic principles, and how people may - or may not - interact in the future. As with any discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the website, pamphlets, videos, books and other products, either directly or indirectly, are expressly disclaimed by the author.

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